News Column

LAKELAND FINANCIAL CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

August 11, 2014

OVERVIEW

Net income in the first six months of 2014 was $21.2 million, up 14.8% from $18.5 million for the comparable period of 2013. Diluted income per common share was $1.27 in the first six months of 2014, up 13.4% from $1.12 in the comparable period of 2013. Return on average total assets was 1.32% in the first six months of 2014 versus 1.26% in the comparable period of 2013. The equity to average assets ratio was 10.23% in the first six months of 2014 versus 10.34% in the comparable period of 2013. Net income in the second quarter of 2014 was $11.3 million, up 22.5% from $9.2 million for the comparable period of 2013. Diluted income per common share was $0.68 in the second quarter of 2014, up 21.4% from $0.56 in the comparable period of 2013. Return on average total assets was 1.37% in the second quarter of 2014 versus 1.24% in the comparable period of 2013. The equity to average assets ratio was 10.18% in the second quarter of 2014 versus 10.38% in the comparable period of 2013. Total assets were $3.419 billion as of June 30, 2014 versus $3.176 billion as of December 31, 2013, an increase of $243.3 million, or 7.7%. This increase was primarily due to a $138.2 million increase in total loans.



CRITICAL ACCOUNTING POLICIES

Certain of the Company's accounting policies are important to the portrayal of the Company's financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Some of the facts and circumstances which could affect these judgments include changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan losses and the valuation and other-than-temporary impairment of investment securities.



Allowance for Loan Losses

The Company maintains an allowance for loan losses to provide for probable incurred credit losses. Loan losses are charged against the allowance when management believes that the principal is uncollectable. Subsequent recoveries, if any, are credited to the allowance. Allocations of the allowance are made for specific loans and for pools of similar types of loans, although the entire allowance is available for any loan that, in management's judgment, should be charged against the allowance. A provision for loan losses is taken based on management's ongoing evaluation of the appropriate allowance balance. A formal evaluation of the adequacy of the loan loss allowance is conducted monthly. The ultimate recovery of all loans is susceptible to future market factors beyond the Company's control. The level of loan loss provision is influenced by growth in the overall loan portfolio, emerging market risk, emerging concentration risk, commercial loan focus and large credit concentration, new industry lending activity, general economic conditions and historical loss analysis. In addition, management gives consideration to changes in the allocation for specific watch list credits in determining the appropriate level of the loan loss provision. Furthermore, management's overall view on credit quality is a factor in the determination of the provision. The determination of the appropriate allowance is inherently subjective, as it requires significant estimates by management. The Company has an established process to determine the adequacy of the allowance for loan losses that generally includes consideration of the following factors: changes in the nature and volume of the loan portfolio, overall portfolio quality and current economic conditions that may affect the borrowers' ability to repay. Consideration is not limited to these factors although they represent the most commonly cited factors. With respect to specific allocation levels for individual credits, management considers the amounts and timing of expected future cash flows and the current valuation of collateral as the primary measures. Management also considers trends in adversely classified loans based upon an ongoing review of those credits. With respect to pools of similar loans, allocations are assigned based upon historical experience unless the rate of loss is expected to be greater than historical losses as noted below. A detailed analysis is performed on loans that are classified but determined not to be impaired which incorporates probability of default with a loss given default scenario to develop non-specific allocations for the loan pool. These allocations may be adjusted based on the other factors cited above. An appropriate level of general allowance for pooled loans is determined after considering the following: application of historical loss percentages, emerging market risk, commercial loan focus and large credit concentration, new industry lending activity and general economic conditions. It is also possible that the following could affect the overall process: social, political, economic and terrorist events or activities. All of these factors are susceptible to change, which may be significant. As a result of this detailed process, the allowance results in two forms of allocations, specific and general. These two components represent the total allowance for loan losses deemed adequate to cover probable losses inherent in the loan portfolio. 35 -------------------------------------------------------------------------------- Commercial loans are subject to a dual standardized grading process administered by the credit administration function. These grade assignments are performed independent of each other and a loan may or may not be graded the same. Specific allowances are established in cases where management has identified significant conditions or circumstances related to an individual credit that indicate the loan is impaired. Considerations with respect to specific allocations for these individual credits include, but are not limited to, the following: (a) does the customer's cash flow or net worth appear insufficient to repay the loan; (b) is there adequate collateral to repay the loan; (c) has the loan been criticized in a regulatory examination; (d) is the loan impaired; (e) are there other reasons where the ultimate collectability of the loan is in question; or (f) are there unique loan characteristics that require special monitoring. Allocations are also applied to categories of loans considered not to be individually impaired, but for which the rate of loss is expected to be consistent with or greater than historical averages. Such allocations are based on past loss experience and information about specific borrower situations and estimated collateral values. In addition, general allocations are made for other pools of loans, including non-classified loans. These general pooled loan allocations are performed for portfolio segments of commercial and industrial, commercial real estate and multi-family, agri-business and agricultural, other commercial, consumer 1-4 family mortgage and other consumer loans, and loans within certain industry categories believed to present unique risk of loss. General allocations of the allowance are primarily made based on a three-year historical average for loan losses for these portfolios, subjectively adjusted for economic factors and portfolio trends. Due to the imprecise nature of estimating the allowance for loan losses, the Company's allowance for loan losses includes an unallocated component. The unallocated component of the allowance for loan losses incorporates the Company's determination, based on its judgment, of inherent losses that may not be fully reflected in other allocations, including factors such as the level of classified credits, economic uncertainties, industry trends impacting specific portfolio segments, broad portfolio quality trends and trends in the composition of the Company's large commercial loan portfolio and related large dollar exposures to individual borrowers.



Valuation and Other-Than-Temporary Impairment of Investment Securities

The fair values of securities available for sale are determined on a recurring basis by obtaining quoted prices on nationally recognized securities exchanges or pricing models, which utilize significant observable inputs such as matrix pricing. This is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities but rather by relying on the securities' relationship to other benchmark quoted securities. Different judgments and assumptions used in pricing could result in different estimates of value. The fair value of certain securities is determined using unobservable inputs, primarily observable inputs of similar securities. At the end of each reporting period, securities held in the investment portfolio are evaluated on an individual security level for other-than-temporary impairment in accordance with current accounting guidance. Impairment is other-than-temporary if the decline in the fair value of the security is below its amortized cost and it is probable that all amounts due according to the contractual terms of a debt security will not be received. Significant judgments are required in determining impairment, which includes making assumptions regarding the estimated prepayments, loss assumptions and the change in interest rates.



We consider the following factors when determining other-than-temporary impairment for a security or investment:

the length of time and the extent to which the market value has been less than

amortized cost; the financial condition and near-term prospects of the issuer;



the underlying fundamentals of the relevant market and the outlook for such

market for the near future; and

our intent and ability to hold the security for a period of time sufficient to

allow for any anticipated recovery in market value.

An additional independent analysis was performed for the non-agency residential mortgage-backed securities to determine if other-than-temporary impairment needed to be recorded for these securities. The independent analysis utilized third party data sources which were then included in projections of the cash flows of the individual securities under several different scenarios based upon assumptions of collateral defaults, prepayment speeds, expected losses and the severity of potential losses. Based upon the initial review using the analysis created with third party sources, securities were identified for further analysis. For any that were identified, management made assumptions as to prepayment speeds, default rates, severity of losses and lag time until losses are actually recorded for each security based upon historical data for each security and other factors. Cash flows for each security using these assumptions were generated and the net present value was computed using an appropriate discount rate (the original accounting yield) for the individual security. The net present value was then compared to the book value of the security to determine if there was any other-than-temporary impairment that must be recorded. During 2013, all non-agency mortgage-backed securities owned as of December 31, 2012 were sold and no additional non-agency mortgage-backed securities were purchased. 36 -------------------------------------------------------------------------------- If, in management's judgment, other-than-temporary impairment exists, the cost basis of the security will be written down to the computed net present value, and the unrealized loss will be transferred from accumulated other comprehensive loss as an immediate reduction of current earnings (as if the loss had been realized in the period of other-than-temporary impairment). In addition, discount accretion will be discontinued on any bond that meets one or both of the following: (1) the rating by S&P, Moody's or Fitch decreases to below "A" and/or (2) the cash flow analysis on a security indicates under any scenario modeled by the third party there is a potential to not receive the full amount invested in the security. RESULTS OF OPERATIONS Overview



Selected income statement information for the three months and six months ended June 30, 2014 and 2013 is presented in the following table:

Three Months Ended June 30, Six Months Ended June 30, (dollars in thousands) 2014 2013 2014 2013 Income Statement Summary: Net interest income $ 25,554$ 21,912$ 50,234$ 43,169 Provision for loan losses 0 0 0 0 Noninterest income 7,592 7,569 15,019 15,050 Noninterest expense 16,084 15,091 32,874 29,984 Other Data: Efficiency ratio 48.53% 51.19% 50.38% 51.50% Dilutive EPS $ 0.68$ 0.56$ 1.27$ 1.12 Tangible capital ratio 9.96% 10.25% 9.96% 10.25% Net charge-offs to average loans 0.08% 0.03% 0.25% 0.07% Net interest margin 3.34% 3.20% 3.35% 3.19%



Noninterest income to total revenue 22.90% 25.67% 23.02% 25.85%

Net Income Net income was $21.2 million in the first six months of 2014, an increase of $2.7 million, or 14.8%, versus net income of $18.5 million in the first six months of 2013. Net interest income increased $7.1 million, or 16.4%, to $50.2 million versus $43.2 million in the first six months of 2013. Net interest income increased primarily due to a 10.6% increase in average earning assets. Significantly affecting average earning assets during 2014 was an increase of 16.0% in the commercial loan portfolio, which reflects our continuing strategic focus on commercial lending. The net interest margin was 3.35% in the first six months of 2014 versus 3.19% in 2013. The higher margin reflected a decline in funding costs offset by lower yields on earning assets. Net income was $11.3 million in the second quarter of 2014, an increase of $2.1 million, or 22.5%, versus net income of $9.2 million in the second quarter of 2013. Net interest income increased $3.6 million, or 16.6%, to $25.6 million versus $21.9 million in the second quarter of 2013. Net interest income increased primarily due to a 12.0% increase in average earning assets, driven by an increase of 17.1% in the commercial loan portfolio. The net interest margin was 3.34% in the second quarter of 2014 versus 3.20% in 2013. The higher margin reflected a decline in funding costs offset by lower yields on earning assets. Earnings for the first quarter of 2014 as well as the second quarter of 2013 were negatively impacted by non-cash provisions for state income tax expense of $431,000 and $465,000, respectively, which resulted from revaluations of the company's state deferred tax items. During both of the quarterly periods, the Indiana legislature approved new tax rates for financial institutions. The tax rate, currently 8.0%, is scheduled to drop in phases to 4.9% for 2023. This lower state tax rate going forward will reduce the benefit provided by the Company's existing deferred tax items. Excluding the effect of these non-cash adjustments, net income would have increased by 14.3% and 16.6%, respectively, for the six months and three months ended June 30, 2014 versus the comparable periods of 2013. 37

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Net Interest Income

The following tables set forth consolidated information regarding average balances and rates: Six Months Ended June 30, 2014 2013 Average Interest Yield (1)/ Average Interest Yield (1)/ (fully tax equivalent basis, dollars in thousands) Balance Income Rate Balance Income Rate Earning assets



Loans:

Taxable (2)(3) $ 2,581,465$ 51,604 4.03 % $ 2,271,373$ 48,874 4.34 %

Tax exempt (1) 10,978 336 6.17 8,750 308 7.09 Investments: (1) Available for sale 473,876 6,521 2.78 480,376 4,359 1.83 Short-term investments 5,368 2 0.08 7,291 3 0.08 Interest bearing deposits 4,297 17 0.80 14,214 33 0.47 Total earning assets $ 3,075,984$ 58,480 3.83 % $ 2,782,004$ 53,577 3.88 % Less: Allowance for loan losses (47,340) (51,188) Nonearning Assets Cash and due from banks 72,766 86,994 Premises and equipment 39,712 34,645 Other nonearning assets 112,708 110,610 Total assets $ 3,253,830$ 2,963,065 Interest bearing liabilities Savings deposits $ 239,243$ 265 0.22 % $ 223,625$ 351 0.32 % Interest bearing checking accounts 1,146,784 2,255 0.40 1,020,736 3,058 0.60 Time deposits: In denominations under $100,000 280,994 1,589 1.14 344,720 2,498 1.46 In denominations over $100,000 579,171 2,413 0.84 508,607 2,869 1.14 Miscellaneous short-term borrowings 159,113 255 0.32 124,279 203 0.33 Long-term borrowings and subordinated debentures (4) 30,964 509 3.32 33,866 568 3.38 Total interest bearing liabilities $ 2,436,269$ 7,286 0.60 % $ 2,255,833$ 9,547 0.85 % Noninterest bearing liabilities Demand deposits 469,561 383,993 Other liabilities 14,984 16,899 Stockholders' equity 333,016 306,340 Total liabilities and stockholders' equity $ 3,253,830$ 2,963,065 Interest Margin Recap Interest income/average earning assets 58,480 3.83 53,577 3.88 Interest expense/average earning assets 7,286 0.48 9,547 0.69 Net interest income and margin $ 51,194 3.35 % $ 44,030 3.19 %



(1) Tax exempt income was converted to a fully taxable equivalent basis

at a 35 percent tax rate for 2014 and 2013. The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA") adjustment applicable to nondeductible interest expenses. (2) Loan fees, which are immaterial in relation to total taxable loan



interest income for the six months ended June 30, 2014 and 2013, are

included as taxable loan interest income. (3) Nonaccrual loans are included in the average balance of taxable loans. 38

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Three Months Ended June 30, 2014 2013 Average Interest Yield (1)/ Average Interest Yield (1)/ (fully tax equivalent basis, dollars in thousands) Balance Income Rate Balance Income Rate Earning assets



Loans:

Taxable (2)(3) $ 2,632,012$ 26,270 4.00 % $ 2,295,787$ 24,388 4.26 %

Tax exempt (1) 13,660 187 5.50 8,684 153 7.08 Investments: (1) Available for sale 474,561 3,266 2.76 482,628 2,311 1.92 Short-term investments 5,257 1 0.08 5,446 1 0.07 Interest bearing deposits 4,438 10 0.90 3,380 11 1.31 Total earning assets $ 3,129,928$ 29,734 3.81 % $ 2,795,925$ 26,864 3.85 % Less: Allowance for loan losses (46,101) (50,736) Nonearning Assets Cash and due from banks 83,670 91,725 Premises and equipment 39,795 34,574 Other nonearning assets 112,503 110,662 Total assets $ 3,319,795$ 2,982,150 Interest bearing liabilities Savings deposits $ 236,358$ 131 0.22 % $ 230,348$ 179 0.31 % Interest bearing checking accounts 1,193,073 1,193 0.40 1,041,918 1,418 0.55 Time deposits: In denominations under $100,000 276,571 766 1.11 337,016 1,198 1.43 In denominations over $100,000 606,747 1,245 0.82 493,642 1,344 1.09 Miscellaneous short-term borrowings 147,620 104 0.28 134,341 112 0.33 Long-term borrowings and subordinated debentures (4) 30,963 257 3.33 30,965 261 3.38 Total interest bearing liabilities $ 2,491,332$ 3,696 0.60 % $ 2,268,230$ 4,512 0.80 % Noninterest bearing liabilities Demand deposits 475,394 387,191 Other liabilities 15,150 17,312 Stockholders' equity 337,919 309,417 Total liabilities and stockholders' equity $ 3,319,795$ 2,982,150 Interest Margin Recap Interest income/average earning assets 29,734 3.81 26,864 3.85 Interest expense/average earning assets 3,696 0.47 4,512 0.65 Net interest income and margin $ 26,038 3.34 % $ 22,352 3.20 %



(1) Tax exempt income was converted to a fully taxable equivalent basis

at a 35 percent tax rate for 2014 and 2013. The tax equivalent rate for tax exempt loans and tax exempt securities acquired after January 1, 1983 included the Tax Equity and Fiscal Responsibility Act of 1982 ("TEFRA") adjustment applicable to nondeductible interest expenses. (2) Loan fees, which are immaterial in relation to total taxable loan



interest income for the three months ended June 30, 2014 and 2013,

are included as taxable loan interest income. (3) Nonaccrual loans are included in the average balance of taxable

loans.

Net interest income increased $7.1 million, or 16.4%, for the six months ended June 30, 2014 compared with the first six months of 2013. The increased level of net interest income during the first six months of 2014 compared with the first six months of 2013 was largely driven by an increase in net earning assets as well as a deceleration in the amortization of premiums on agency mortgage-backed securities. The deceleration was primarily the result of rising long-term mortgage interest rates which have reduced prepayments in the loans underlying the securities. In addition, the Company's cost of funds decreased by 21 basis points during the first six months of 2014 compared to the first six months of 2013. The tax equivalent net interest margin was 3.35% for the first six months of 2014 compared to 3.19% during the first six months of 2013. The yield on earning assets totaled 3.83% during the six months ended June 30, 2014 compared to 3.88% in the same period of 2013 while the cost of funds (expressed as a percentage of average earning assets) totaled 0.48% during the first six months of 2014 compared to 0.69% in the same period of 2013. Net interest income increased $3.6 million, or 16.6%, for the second quarter of 2014 compared to the second quarter of 2013. The increase was driven by an increase in net earning assets. In addition, the Company's cost of funds decreased by 18 basis points during the second quarter of 2014 compared to the second quarter of 2013. The tax equivalent net interest margin was 3.34% for the second quarter of 2014 compared to 3.20% during the second quarter of 2013. 39 -------------------------------------------------------------------------------- The decline in the Company's cost of funds during the six month and three month periods ended June 30, 2014, compared to the same periods in 2013 was largely driven by a continued decline in deposit rates as well as increases in average noninterest bearing demand deposits. Average earning assets increased by $294.0 million for the six months ended June 30, 2014 compared with the same period of 2013. Average loans outstanding increased $312.3 million during the six months ended June 30, 2014 compared with the first six months of 2013, with most of the growth being in commercial loans. The average securities portfolio decreased $6.5 million in the six months ended June 30, 2014 compared with the first six months of 2013. Average earning assets increased by $334.0 million for the second quarter of 2014 compared with the same period of 2013. Average loans outstanding increased $341.2 million during the second quarter of 2014 compared with the second quarter of 2013, with most of the growth being in commercial loans. The average securities portfolio decreased $8.1 million in the second quarter 2014 compared with the second quarter of 2013.



Provision for Loan Losses

No provisions for loan loss expense were recorded during the six month and three month periods ended June 30, 2014 and 2013. The allowance for loan losses represented 1.71% of the loan portfolio, versus 1.92% at December 31, 2013 and 2.17% at June 30, 2013. Factors impacting the decision not to record a provision in the first six months of 2014 included the stabilization or improvement in key loan quality metrics including strong reserve coverage of nonperforming loans, a decrease in historical loss percentages, continuing signs of stabilization in economic conditions in the Company's markets and sustained signs of improvement in borrower performance and future prospects. In addition, management gave consideration to changes in the allocation for specific watch list credits in determining the appropriate level of the loan loss provision. Management's overall view on current credit quality was also a factor in the determination of the provision for loan losses. The Company's management continues to monitor the adequacy of the provision based on loan levels, asset quality, economic conditions and other factors that may influence the assessment of the collectability of loans.



Noninterest Income

Noninterest income categories for the six-month and three-month periods ended June 30, 2014 and 2013 are shown in the following table:

Six Months Ended June 30, Percent (dollars in thousands) 2014 2013 Change Wealth advisory fees $ 2,016$ 1,915 5.3 % Investment brokerage fees 2,040 1,946 4.8 Service charges on deposit accounts 4,499 4,223



6.5

Loan, insurance and service fees 3,215 3,268 (1.6) Merchant card fee income 730 569 28.3 Bank owned life insurance 710 811 12.5 Other income 1,561 1,270 22.9 Mortgage banking income 244 1,047 (76.7) Net securities gains (losses) 4 1 300.0 Total noninterest income $ 15,019$ 15,050 (0.2) % Noninterest income to total revenue 23.0% 25.9% 40

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Three Months Ended June 30, Percent (dollars in thousands) 2014 2013 Change Wealth advisory fees $ 977$ 971 0.6 % Investment brokerage fees 923 997 (7.4) Service charges on deposit accounts 2,348 2,252



4.3

Loan, insurance and service fees 1,757 1,812 (3.0) Merchant card fee income 380 293 29.7 Bank owned life insurance 338 418 (19.1) Other income 686 288 138.2 Mortgage banking income 179 538 (66.7) Net securities gains (losses) 4 0 N/A Total noninterest income $ 7,592$ 7,569 0.3 % Noninterest income to total revenue 22.9% 25.7% The Company's noninterest income was virtually unchanged during the six month and three month periods ended June 30, 2014 compared to the same periods in 2013. Noninterest income was negatively impacted by decreases in mortgage banking income, driven by lower production volumes due to higher long-term mortgage rates. Loans originated for sale totaled $16.8 million and $9.8 million, respectively in the six month and three month periods ended June 30, 2014, versus $51.6 million and $22.2 million for the comparable periods of 2013. Noninterest income was positively impacted by increases in service charges on deposit accounts driven by increases in account analysis service charges on commercial checking accounts, and increases in other income driven by higher interest rate swap fees. Noninterest Expense



Noninterest expense categories for the six-month and three-month periods ended June 30, 2014 and 2013 are shown in the following table:

Six Months Ended June 30, Percent (dollars in thousands) 2014 2013 Change Salaries and employee benefits $ 19,454$ 18,056 7.7 % Net occupancy expense 2,013 1,719 17.1 Equipment costs 1,534 1,263 21.5 Data processing fees and supplies 2,984 2,672



11.7

Corporate and business development 897 849



5.7

FDIC insurance and other regulatory fees 965 921 4.8 Professional fees 1,536 1,348 13.9 Other expense 3,491 3,156 10.6 Total noninterest expense $ 32,874$ 29,984 9.6 % 41

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Three Months Ended June 30, Percent (dollars in thousands) 2014 2013 Change Salaries and employee benefits $ 9,467$ 8,891 6.5 % Net occupancy expense 903 873 3.4 Equipment costs 761 654 16.4 Data processing fees and supplies 1,493 1,379



8.3

Corporate and business development 481 443



8.6

FDIC insurance and other regulatory fees 488 458 6.6 Professional fees 736 753 (2.3) Other expense 1,755 1,640 7.0 Total noninterest expense $ 16,084$ 15,091 6.6 % The Company's noninterest expense increased $2.9 million and $993,000, respectively, in the six-month and three-month periods ended June 30, 2014 versus the same periods in 2013. Salaries and employee benefits increased by $1.4 million and $576,000, respectively, driven by higher performance-based compensation costs, staff additions and normal merit increases. Data processing fees increased by $312,000 and $114,000, respectively, due to a larger customer base as well as greater utilization of services from the Company's core processor, which the Company expects will improve marketing and cross-selling initiatives. Equipment costs increased $271,000 and $107,000, respectively, driven by higher depreciation expenses related to operating leases. In addition, other expenses increased primarily due to higher advertising costs. The Company's efficiency ratio improved to 50.4% and 48.5%, respectively, for the six-month and three-month periods ended June 30, 2014 compared to 51.5% and 51.1% for the comparable periods in 2013.



Income Taxes

Income tax expense increased $1.4 million, or 14.4%, for the first six months of 2014, compared to the same period in 2013. The combined state franchise tax expense and the federal income tax expense, as a percentage of income before income tax expense, was 34.5% during the first six months of 2014 and 2013. The combined tax expense was 33.7% for the second quarter of 2014, compared to 35.8% for the second quarter of 2013.



FINANCIAL CONDITION

Overview

Total assets of the Company were $3.419 billion as of June 30, 2014, an increase of $243.3 million, or 7.7%, when compared to $3.176 billion as of December 31, 2013. Total loans increased by $138.2 million, or 5.5%, to $2.673 billion at June 30, 2014 from $2.535 billion at December 31, 2013. Funding for the loan growth came from a $281.7 million increase in deposits offset by a $58.9 million decrease in short-term borrowings.



Uses of Funds

Total Cash and Cash Equivalents

Total cash and cash equivalents increased by $97.3 million, or 154.2%, to $160.4 million at June 30, 2014, from $63.1 million at December 31, 2013. The increase was primarily due to an $85 million short-term advance from the Federal Home Loan Bank of Indianapolis. The advance was taken out on June 30, 2014 and the funds from the advance were deployed within a few business days following quarter end. 42

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Investment Portfolio



The amortized cost and the fair value of securities as of June 30, 2014 and December 31, 2013 were as follows:

June 30, 2014 December 31, 2013 Amortized Fair Amortized Fair (dollars in thousands) Cost Value Cost Value U.S. Treasury securities $ 1,000$ 1,006$ 1,001$ 1,017 Agency residential mortgage-backed securities 370,111 374,578 374,611 371,977 State and municipal securities 97,236 100,278 95,388 95,973 Total $ 468,347$ 475,862$ 471,000$ 468,967 At June 30, 2014 and December 31, 2013, there were no holdings of securities of any one issuer, other than the U.S. government, government agencies and government sponsored agencies, in an amount greater than 10% of stockholders' equity. Purchases of securities available for sale totaled $29.5 million in the first six months of 2014. Paydowns from prepayments and scheduled payments of $28.2 million were received in the first six months of 2014, and the amortization of premiums, net of the accretion of discounts, was $2.9 million. Maturities and calls of securities totaled $1.0 million in the first six months of 2014. No other-than-temporary impairment was recognized in the first six months of 2014. The investment portfolio is managed to provide for an appropriate balance between, liquidity, credit risk and investment return and to limit the Company's exposure to risk to an acceptable level. The Company does not trade or invest in or sponsor certain unregistered investment companies defined as hedge funds and private equity funds in the Volcker Rule.



Real Estate Mortgage Loans HFS

Real estate mortgage loans held-for-sale decreased by $709,000, or 39.9%, to $1.1 million at June 30, 2014, from $1.8 million at December 31, 2013. The balance of this asset category is subject to a high degree of variability depending on, among other things, recent mortgage loan rates and the timing of loan sales into the secondary market. The Company generally sells all of the mortgage loans it originates on the secondary market. Proceeds from sales totaled $17.9 million in the first six months of 2014.



Loan Portfolio

The loan portfolio by class as of June 30, 2014 and December 31, 2013 is summarized as follows: Current June 30, December 31, Period (dollars in thousands) 2014 2013 Change



Commercial and industrial loans $ 1,035,946 38.7 % $ 901,567

35.6 % $ 134,379 Commercial real estate and multi-family residential loans 1,018,023 38.1 986,207 38.9 31,816 Agri-business and agricultural loans 212,679 8.0 254,029 10.0 (41,350) Other commercial loans 72,097 2.7 70,770 2.8 1,327 Consumer 1-4 family mortgage loans 291,217 10.9 277,030 10.9 14,187 Other consumer loans 43,907 1.6 46,125 1.8 (2,218) Subtotal 2,673,869 100.0 % 2,535,728 100.0 % 138,141 Less: Allowance for loan losses (45,605) (48,797) 3,192 Net deferred loan fees (542) (630) 88 Loans, net $ 2,627,722$ 2,486,301$ 141,421 Total loans, excluding real estate mortgage loans held for sale, increased by $138.1 million to $2.674 billion at June 30, 2014 from $2.536 billion at December 31, 2013. The increase was concentrated in the commercial and commercial real estate categories and reflected the Company's long standing strategic plan that is focused on expanding and growing the commercial lending business throughout our market areas. The increase was partially offset by seasonal declines in agri-business loans. 43 --------------------------------------------------------------------------------



The following table summarizes the Company's non-performing assets as of June 30, 2014 and December 31, 2013:

June 30, December 31, (dollars in thousands) 2014



2013

Nonaccrual loans including nonaccrual troubled debt restructured loans

$ 14,071 $



23,898

Loans past due over 90 days and still accruing 4 46 Total nonperforming loans $ 14,075$ 23,944 Other real estate owned 1,136 469 Repossessions 5 12 Total nonperforming assets $ 15,216$ 24,425 Impaired loans including troubled debt restructurings $ 32,049 $



43,218

Nonperforming loans to total loans 0.53%



0.94%

Nonperforming assets to total assets 0.45%



0.77%

Performing troubled debt restructured loans $ 15,607 $



17,714

Nonperforming troubled debt restructured loans (included in nonaccrual loans) 10,349



18,531

Total troubled debt restructured loans $ 25,956 $



36,245

Total nonperforming assets decreased by $9.2 million, or 37.7%, to $15.2 million during the six-month period ended June 30, 2014. The decrease in nonperforming assets primarily resulted from the sale, to an independent party, of a single commercial relationship consisting of three loans totaling $6.7 million. The three loans were accounted for as troubled debt restructurings. The Company received proceeds of $4.3 million and recognized charge offs of $2.4 million as a result of the sale. The amount charged-off had previously been reserved for by the Company. In addition, one commercial credit of $1.4 million was removed from the impaired category due to improved performance.



Net charge-offs totaled $532,000 in the second quarter of 2014, versus net charge-offs of $183,000 during the second quarter of 2013 and net charge-offs of $2.7 million during the first quarter of 2014.

A loan is impaired when full payment under the original loan terms is not expected. Impairment for smaller loans that are similar in nature and which are not in nonaccrual or troubled debt restructured status, such as residential mortgage, consumer, and credit card loans, is determined based on the class of loans and impairment is determined on an individual loan basis for other loans. If a loan is impaired, a portion of the allowance may be allocated so that the loan is reported, net, at the present value of estimated future cash flow or at the fair value of collateral if repayment is expected solely from the collateral. Total impaired loans decreased by $11.2 million, or 25.8%, to $32.0 million at June 30, 2014 from $43.2 million at December 31, 2013. The decrease in the impaired loans category was primarily due to the sale proceeds received and charge offs recognized on a single commercial relationship consisting of three impaired loans totaling $6.7 million. In addition, one commercial credit of $1.4 million was removed from the impaired category due to improved performance. Loans are charged against the allowance for loan losses when management believes that the principal is uncollectible. Subsequent recoveries, if any, are credited to the allowance. The allowance is an amount that management believes will be adequate to absorb probable incurred credit losses relating to specifically identified loans based on an evaluation of the loans by management, as well as other probable incurred losses inherent in the loan portfolio. The evaluations take into consideration such factors as changes in the nature and volume of the loan portfolio, overall portfolio quality, review of specific problem loans and current economic conditions that may affect the borrower's ability to repay. Management also considers trends in adversely classified loans based upon a monthly review of those credits. An appropriate level of general allowance is determined after considering the following factors: application of historical loss percentages, emerging market risk, commercial loan focus and large credit concentrations, new industry lending activity and current economic conditions. Federal regulations require insured institutions to classify their own assets on a regular basis. The regulations provide for three categories of classified loans: Substandard, Doubtful and Loss. The regulations also contain a Special Mention category. Special Mention is defined as loans that do not currently expose an insured institution to a sufficient degree of risk to warrant classification as Substandard, Doubtful or Loss but do possess credit deficiencies or potential weaknesses deserving management's close attention. The Company's policy is to establish a specific allowance for loan losses for any assets where management has identified conditions or circumstances that indicate an asset is impaired. If an asset or portion thereof is classified as a loss, the Company's policy is to either establish specified allowances for loan losses in the amount of 100% of the portion of the asset classified loss or charge-off such amount. 44

-------------------------------------------------------------------------------- At June 30, 2014, the allowance for loan losses was 1.71% of total loans outstanding, versus 1.92% of total loans outstanding at December 31, 2013. At June 30, 2014, management believed the allowance for loan losses was at a level commensurate with the overall risk exposure of the loan portfolio. However, if economic conditions do not continue to improve, certain borrowers may experience difficulty and the level of nonperforming loans, charge-offs and delinquencies could rise and require increases in the allowance for loan losses. The process of identifying probable credit losses is a subjective process. Therefore, the Company maintains a general allowance to cover probable incurred credit losses within the entire portfolio. The methodology management uses to determine the adequacy of the loan loss reserve includes the considerations below. The Company has a relatively high percentage of commercial and commercial real estate loans, most of which are extended to small or medium-sized businesses from a wide variety of industries. Generally, this type of lending has more credit risk than other types of lending because of the size and diversity of the credits. The Company manages this risk by adjusting its pricing to the perceived risk of each individual credit and by diversifying the portfolio by customer, product, industry and geography. As of June 30, 2014, on the basis of management's review of the loan portfolio, the Company had 94 credits totaling $149.5 million on the classified loan list versus 98 credits totaling $165.1 million on December 31, 2013. As of June 30, 2014, the Company had $86.6 million of assets classified as Special Mention, $61.7 million classified as Substandard, $0 classified as Doubtful and $0 classified as Loss as compared to $88.8 million, $73.7 million, $0 and $0, respectively at December 31, 2013. Allowance estimates are developed by management after taking into account actual loss experience adjusted for current economic conditions. The Company has regular discussions regarding this methodology with regulatory authorities. Allowance estimates are considered a prudent measurement of the risk in the Company's loan portfolio and are applied to individual loans based on loan type. In accordance with current accounting guidance, the allowance is provided for losses that have been incurred as of the balance sheet date and is based on past events and current economic conditions and does not include the effects of expected losses on specific loans or groups of loans that are related to future events or expected changes in economic conditions. For a more thorough discussion of the allowance for loan losses methodology see the Critical Accounting Policies section of this Item 2. The allowance for loan losses decreased 6.5%, or $3.2 million, from $48.8 million at December 31, 2013 to $45.6 million at June 30, 2014. Pooled loan allocations increased from $39.5 million at December 31, 2013 to $39.7 million at June 30, 2014, which was due to an increase in pooled loan balances as well as management's view of current credit quality and the current economic environment. Impaired loan allocations decreased $3.4 million from $9.3 million at December 31, 2013 to $5.9 million at June 30, 2014. This decrease in impaired allocations was primarily due to decreases in the allocations of existing impaired loans as well as reductions to the impaired loans category. The unallocated component of the allowance for loan losses was $3.3 million at June 30, 2014 and $3.5 million at December 31, 2013. While general trends in the overall economy and credit quality were stable or favorable, the Company believes that the unallocated component is appropriate given the uncertainty that exists regarding near term economic conditions. Most of the Company's loan growth has been concentrated in the commercial loan portfolio, which can result in overall asset quality being influenced by a small number of credits. Management has historically considered growth and portfolio composition when determining loan loss allocations. Management believes that it is prudent to continue to provide for loan losses in a manner consistent with its historical approach due to the loan growth described above and current economic conditions. Economic conditions in the Company's markets have generally improved and stabilized, and management is cautiously optimistic that the recovery is positively impacting its borrowers. The unemployment rate in Indiana of 5.8% is below the national rate of 6.2%. In addition the unemployment rate of the Indiana counties we operate in has declined as compared to a year ago. While unemployment figures have improved since a year ago, the labor participation rate remains lower than one year ago. While the Company has seen indications of improved economic conditions in its markets, including commercial real estate activity and manufacturing growth, they are not wide spread or particularly strong improvements. The Company's continued growth strategy promotes diversification among industries as well as continued focus on enforcement of a strong credit environment and an aggressive position in loan work-out situations. Although the Company believes that historical industry-specific issues in the Company's markets have improved, the economic environment impacting the Company's entire geographic footprint will continue to present challenges 45

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Sources of Funds The following table summarizes deposits and borrowings as of June 30, 2014 and December 31, 2013: Current June 30, December 31, Period (dollars in thousands) 2014 2013 Change Non-interest bearing demand deposits $ 506,771$ 479,606$ 27,165 Interest bearing demand, savings & money market accounts 1,441,484 1,338,653



102,831

Time deposits under $100,000 274,814 291,566



(16,752)

Time deposits of $100,000 or more 604,676 436,243 168,433 Total deposits 2,827,745 2,546,068 281,677 Short-term borrowings 202,961 261,876 (58,915) Long-term borrowings 35 37 (2) Subordinated debentures 30,928 30,928 0 Total borrowings 233,924 292,841 (58,917) Total funding sources $ 3,061,669$ 2,838,909$ 222,760 Deposits and Borrowings Total deposits increased by $281.7 million, or 11.1%, from December 31, 2013. The growth in deposits consisted of $170.1 million in core deposit growth and an increase of $111.6 million in brokered deposits. Core deposit growth was concentrated in interest bearing transaction accounts, public fund certificates of deposit of $100,000 or more and money market accounts. The increase in money market balances as well as a decline in time deposits under $100,000 was reflective of the ongoing low interest rate environment and consumers' desire to keep funds in a more liquid short-term deposit vehicle, in anticipation of higher rates in the future. Total brokered deposits were $141.4 million at June 30, 2014 compared to $29.8 million at December 31, 2013. Total public funds deposits, including public funds transaction accounts, were $808.1 million at June 30, 2014 compared to $549.7 at December 31, 2013. Total borrowings decreased by $58.9 million, or 20.1%, from December 31, 2013. Most of the decrease was from a decrease in short-term advances from the Federal Home Loan Bank of Indianapolis, securities sold under agreements to repurchase and federal funds purchased. The Company used wholesale funding, including brokered deposits and Federal Home Loan Bank advances, to fund part of its loan growth and to help maintain its desired interest rate risk position. 46

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Capital As of June 30, 2014, total stockholders' equity was $343.5 million, an increase of $21.6 million, or 6.7%, from $321.9 million at December 31, 2013. In addition to net income of $21.2 million, other significant changes in equity during the first six months of 2014 included $6.6 million of dividends paid. The accumulated other comprehensive income component of equity increased $5.8 million during the six months ended June 30, 2014, driven by changes in the fair values of available-for-sale securities. The impact on equity by other comprehensive income is not included in regulatory capital. The banking regulators have established guidelines for leverage capital requirements, expressed in terms of Tier 1, or core capital, as a percentage of average assets, to measure the soundness of a financial institution. In addition, banking regulators have established risk-based capital guidelines for U.S. banking organizations. The actual capital amounts and ratios of Lakeland Financial Corporation and Lake City Bank as of June 30, 2014 and December 31, 2013, are presented in the table below: Minimum Required to Minimum Required Be Well Capitalized For Capital Under Prompt Corrective Actual Adequacy Purposes Action Regulations (dollars in thousands) Amount Ratio Amount Ratio Amount Ratio As of June 30, 2014: Total Capital (to Risk Weighted Assets) Consolidated $ 400,513 14.12% $ 226,997 8.00% $ 283,747 10.00% Bank $ 389,318 13.76% $ 226,347 8.00% $ 282,934 10.00% Tier I Capital (to Risk Weighted Assets) Consolidated $ 364,919 12.86% $ 113,499 4.00% $ 170,248 6.00% Bank $ 353,825 12.51% $ 113,174 4.00% $ 169,760 6.00% Tier I Capital (to Average Assets) Consolidated $ 364,919 11.01% $ 132,583 4.00% $ 165,729 5.00% Bank $ 353,825 10.72% $ 132,035 4.00% $ 165,043 5.00% As of December 31, 2013: Total Capital (to Risk Weighted Assets) Consolidated $ 382,951 14.23% $ 215,229 8.00% $ 269,036 10.00% Bank $ 373,685 13.92% $ 214,704 8.00% $ 268,380 10.00% Tier I Capital (to Risk Weighted Assets) Consolidated $ 349,134 12.98% $ 107,614 4.00% $ 161,422 6.00% Bank $ 339,949 12.67% $ 107,352 4.00% $ 161,028 6.00% Tier I Capital (to Average Assets) Consolidated $ 349,134 11.25% $ 124,152 4.00% $ 155,190 5.00% Bank $ 339,949 10.98% $ 123,809 4.00% $ 154,761 5.00% Beginning January 1, 2015, the Company and Bank will be subject to the new capital regulations of Basel III. The new regulations establish higher minimum risk-based capital ratio requirements, a new common equity Tier 1 risk-based capital ratio and a new capital conservation buffer. The new regulations also include revisions to the definition of capital and changes in the risk-weighting on certain assets. To be considered "well capitalized," as well as in compliance with the capital conservation buffer, a financial institution must maintain a 7.0% common equity Tier 1 risk-based capital ratio, an 8.5% Tier 1 risk-based capital ratio and a 10.5% total risk-based capital ratio. The capital conservation buffer is being phased-in and will be in full effect beginning January 1, 2019. Under the new regulations, all financial institutions must maintain a Tier 1 leverage ratio of 4% to be considered "adequately capitalized" and 5% to be considered "well-capitalized." Management has completed a preliminary analysis of the impact of these new regulations to the capital ratios of both the Company, and the Bank and estimates that the ratios for both the Company and the Bank would exceed the capital ratio requirements to be considered "well-capitalized" and in compliance with the capital conservation buffer under Basel III if they were effective at June 30, 2014. 47 --------------------------------------------------------------------------------



FORWARD-LOOKING STATEMENTS

This document (including information incorporated by reference) contains, and future oral and written statements of the Company and its management may contain, forward-looking statements, within the meaning of such term in the Private Securities Litigation Reform Act of 1995, with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company. Forward-looking statements, which may be based upon beliefs, expectations and assumptions of the Company's management and on information currently available to management, are generally identifiable by the use of words such as "believe," "expect," "anticipate," "plan," "intend," "estimate," "may," "will," "would," "could," "should" or other similar expressions. Additionally, all statements in this document, including forward-looking statements, speak only as of the date they are made, and the Company undertakes no obligation to update any statement in light of new information or future events. The Company's ability to predict results or the actual effect of future plans or strategies is inherently uncertain. The factors, which could have a material adverse effect on the operations and future prospects of the Company and its subsidiaries, are detailed in the "Risk Factors" section included under Item 1A. of Part I of our Form 10-K. In addition to the risk factors described in that section, there are other factors that may impact any public company, including ours, which could have a material adverse effect on the operations and future prospects of the Company and its subsidiaries. These additional factors include, but are not limited to, the following:



Legislative or regulatory changes or actions, including the "Dodd-Frank Wall

Street Reform and Consumer Protection Act" and the regulations required to be

promulgated thereunder, as well as rules recently implemented by the federal

banking regulatory agencies concerning certain increased capital requirements,

among other items, which may adversely affect the business of the Company and

its subsidiaries.

The costs, effects and outcomes of existing or future litigation.

Changes in accounting policies and practices, as may be adopted by state and

federal regulatory agencies, the Financial Accounting Standards Board, the

Securities and Exchange Commission and the Public Company Accounting Oversight

Board.

The ability of the Company to manage risks associated with the foregoing as

well as anticipated.



These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements.


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